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Contracts of Guarantee and Indemnity

MBA-Unit-4

In this unit you come to know when a company needs some money for its business it approaches a bank. The bank requires that the managing director M promises to repay the loan personally should the company default. When the directors of the company including M execute the promissory note on behalf of the company, they sign as companys officials. M, the managing director signs again as an individual. The relationship between M and the bank is called a guarantee or suretyship. It is a contractual relationship resulting from the unconditional promise of M (known as the surety or guarantor) to repay the loan to the creditor (the bank) for the obligation of the principal debtor (the company) should it default. If the company fails to repay the loan, the bank can approach M for the payment.

Introduction

Purpose of guarantee
The contracts of guarantee are among the most common business contracts and are used for a number of purposes. These are: i) The guarantee is generally made use of to secure loans. Thus, a contract of guarantee is for the security of the creditor. ii) The contracts of guarantee are sometimes called performance bonds. iii) Bail bonds, used in criminal law, are a form of contract of guarantee.

Definition and nature of the contract of guarantee


A contract of guarantee is defined as a contract to perform the promise, or discharge the liability, of a third person in case of his default. The person who gives the guarantee is called surety; the person for whom the guarantee is given is called the principal debtor, and the person to whom the guarantee is given is called the creditor. A contract of guarantee may be either oral or in writing. It is clear that in a contract of guarantee there must, in effect, be two contracts, a principal contract between the principal debtor and creditor, and a secondary contract between the creditor and the surety. In a contract of guarantee there are three parties, viz., the creditor, the principal debtor and the surety. Therefore, there is an implied contract also between the principal debtor and the surety.

The contract of surety is not a contract collateral to the contract of the principal debtor, but is an independent contract. There must be a distinct promise on the party of the surety to be assumable for the debt. It is not necessary that the principal contract, between the debtor and the creditor, must exist at the time the contract of guarantee is made; the original contract between the debtor and creditor may be about to come into existence. Similarly, under certain circumstances, a surety may be called upon to pay though principal debtor is not liable at all. Also, where a person gives a guarantee upon a contract that the creditor shall not act upon it until another person has joined in it as co-surety, the guarantee is not valid if that other person does not join

Fiduciary relationship
A contract of guarantee is not a contract uberrimae fidei (requiring utmost good faith). Nevertheless, the suretyship relation is one of trust and confidence and the validity of the contract depends upon good faith on the part of the creditor. A creditor must disclose all those facts which, under the circumstances, the surety would expect not to exist. So where guarantee is given for good conduct of an employee, the employers failure to inform the surety of any breach on the part of employee, will discharge the surety. Similarly, where X guarantees the existing and future liabilities of A to B upto a certain amount which limit has already been exceeded, the contract of guarantee can be avoided on the ground of concealment of a materiel fact. However, it should be noted that it is no part of the creditors duty to inform the surety about all his previous dealings with the debtor.

Kinds of Guarantee
1 Oral or written guarantee A contract of guarantee may either be oral or in writing (Sec.126), though a creditor should always prefer to put it in writing to avoid any dispute regarding the terms, etc. In case of an oral agreement the existence of the agreement itself is very difficult to prove. 2 Specific and continuing guarantee From the point of view of the scope of guarantee a contract of guarantee may either by specific or continuing. A guarantee is a specific guarantee, if it is intended to be applicable to a particular debt and thus comes to end on its repayment. A specific guarantee once given is irrevocable. 3 A guarantee may either be for the whole debt or a part of the debt Difficult questions arise in case of guarantee for a limited amount because there is an important distinction between a guarantee for only a part of the whole debt and a guarantee for the whole debt subject to a limit.

Rights and Obligations of the Creditor


Rights of a creditor 1. The creditor is entitled to demand payment from the surety as soon as the principal debtor refuses to pay or makes default in payment. The liability of the surety cannot be postponed till all other remedies against the principal debtor have been exhausted. In other words, the creditor cannot be asked to exhaust all other remedies against principal debtor before proceeding against surety. The creditor also has a right of general lien on the securities of the surety in his possession. This right, however, arises only when the principal debtor has made default and not before that. 2. Where surety is insolvent, the creditor is entitled to proceed in the suretys insolvency and claim the pro rata dividend.

Obligations imposed on a creditor in a contract of guarantee 1. Not to change any terms of the original contract. The creditor should not change any terms of the original contract without seeking the consent of the surety. Sec.133 provides. any variance made, without the suretys consent, in the terms of the contract between the principal debtor and the creditor, discharges the surety as to the transactions subsequent to the variance. 2. Not to release or discharge the principal debtor. The creditor is under an obligation not to release or discharge the principal debtor. Sec.134 states: The surety is discharged by a contract between the creditor and principal debtor, by which the principal debtor is released, or by any act or omission of the creditor, the legal consequence of which is the discharge of the principal debtor. 3. Not to compound, or give time to, or agree not to sue the principal debtor. Sec.135 provides, A contract between the creditor and the principal debtor, by which the creditor makes a composition with or promises to give time to, or not to use the principal debtor, discharges the surety, unless the surety assents to such contract.

If the time for repayment is extended, the debtor may die or become insane or insolvent or his financial position may become weaker in the meanwhile, with one effect that the suretys remedy to recover the money in case the principal debtor defaults, may be impaired. However, there are certain exceptions. These are: a) Sec.136 states that if the creditor makes an agreement with a third party, but not with the principal debtor, to give extension of time to the principal debtor, surety is not discharged even if his consent has not been sought. b) Mere forbearance on the part of creditor to sue the principal debtor, or to enforce any other remedy against him, does not, in the absence of a provision to the contrary, discharge the surety (Sec.137). c) If the creditor releases one of the co-sureties, the other co-surety (or cosureties) thereby is not discharged. The co-surety released by the creditor is also not released from his liability to the other sureties (Sec.138). 4. Not to do any act inconsistent with the rights of the surety (Sec.139). Where C lends money to B on the security of a joint and several promissory note made in Cs favour by B and by A as surety for B, together with a bill of sale of Bs furniture, which gives power to C to sell the furniture and apply the proceeds in discharge of the note. Subsequently, C sells the furniture, but owing to his misconduct and willful negligence, only a small price is realised, then A is discharged from liability on the note.

Rights, Liabilities and Discharge of Surety


Rights of a surety may be classified under three heads: (i) rights against the creditor, (ii) rights against the principal debtor and (iii) rights against co-sureties.

Rights against the creditor In case of fidelity guarantee, the surety can direct creditor to dismiss the employee whose honesty he has guaranteed, in the event of proved dishonesty of the employee. The creditors failure to do so will exonerate the surety from his liability.

Rights against the principal debtor a) Right of subrogation: Sec.140 lays down that where a surety has paid the guaranteed debt on its becoming due or has performed the guaranteed duty on the default of the principal debtor, he is invested with all the rights which the creditor has against the debtor. In other words, the surety is subrogated to all the rights which the creditor had against the principal debtor. So, if the creditor loses, or without the consent of the surety parts with any securities (whether known to the surety or not) the surety is discharged to the extent of the value of such securities (Sec.141). Further, the creditor must hand over to the surety, the securities in the same condition as they formerly stood in his hands. b) Right to be indemnified: The surety has a right to recover from the principal debtor the amounts which he has rightfully paid under the contract of guarantee.

Rights against co-sureties a) Right of contribution. Where a debt has been guaranteed by more than one person, they are called co-sureties. Sec.146 provides for a right of contribution between them. When a *surety has paid more than his share or a decree has been passed against him for more than his share, he has a right of contribution from the other sureties who are equally bound to pay with him. b) Where, the co-sureties have guaranteed different sums, they are bound under Sec.147 to contribute equally, subject to the limit fixed by their guarantee and not proportionately to the liability undertaken.

Liability of surety Unless the contract provides otherwise, the liability of the surety is co-extensive with that of the principal debtor (Sec.128). In other words, the surety is liable for all those amounts the principal debtor is liable for. The liability of a surety is called as secondary or contingent, as his liability arises only on default by the principal debtor. But as soon as the principal debtor defaults, the liability of the surety begins and runs co-extensive with the liability of the principal debtor, in the sense that the surety will be liable for all those sums for which the principal debtor is liable. The creditor may file a suit against the surety without suing the principal debtor. Further, where the creditor holds securities from the principal debtor for his debt, the creditor need not first exhaust his remedies against the securities before suing the surety, unless the contract specifically so provides. The creditor is even not bound to give notice of the default to the surety, unless it is expressly provided for.

Discharge of surety The liability of surety under a contract of a guarantee comes to an end under any one of the following circumstances: 1. By notice of revocation (Sec.130). A continuing guarantee may at any time be revoked by the surety, as to future transactions, by notice to the creditor. 2. By the death of surety (Sec.131). The death of the surety operates, in the absence of any contract to the contrary, as a revocation of a continuing guarantee, so far as regards future transactions. 3. By variance in terms of the contract (Sec.133). Any variance, made without the suretys consent, in the terms of the contract between the principal debtor and the creditor, discharges the surety as to transactions subsequent to the variance. 4. By release or discharge of principal debtor (Sec.134). The surety is discharged by any contract between the creditor and principal debtor, by which the principal debtor is released, or by any act or omission of the creditor, the legal consequence of which is the discharge of the principal debtor. 5. By compounding with, or giving time to, or agreeing not to sue, principal debtor (Sec.135). A contract between the creditor and the principal debtor by which the creditor makes a composition with, or promises to give time to, or not to sue the principal debtor, discharges the surety. The surety shall, however, be not discharged if (a) he assents to such contract, (b) the contract to give time to the principal debtor is made by the creditor with a third person and not with the principal debtor. 6. By creditors act or omission impairing suretys eventual remedy (Sec.139). If the creditor does any act which is inconsistent with the right of the surety, or omits to do any act which his duty to the surety requires him to do and the eventual remedy of surety himself against the principal debtor is thereby impaired, the surety is discharged. 7. Loss of security. If the creditor loses or parts with any security given to him by the principal debtor at the time the contract of guarantee was made, the surety is discharged to the extent of the value of the security, unless the surety consented to the release of such security

1 Meaning of indemnity Secs.124 and 125 provide for a contract of indemnity. Sec.124 provides that a contract of indemnity is a contract whereby one party promises to save the other from loss caused to him (the promisee) by the conduct of the promisor himself or by the conduct of any other person. A contract of insurance is a glaring example of such type of contracts. A contract of indemnity may arise either by (i) an express promise r (ii) operation of law, e.g., the duty of a principal to indemnify an agent from consequences of all lawful acts done by him as an agent. The contract of indemnity, like any other contract, must have all the essentials of a valid contract. These are two parties in a contraction of identity indemnifier and indemnified. The indemnifier promises to make good the loss of the indemnified

Contract of Indemnity

Rights of the indemnified


He is entitled to recover from the promisor: (i) All damages which he may be compelled to pay in any suit in respect of any matter to which the promise to indemnify applies; (ii) All costs of suit which he may have to pay to such third party, provided in bringing or defending the suit (a) he acted under the authority of the indemnifier or (b) if he did not act in contravention of orders of the indemnifier and in such a way as a prudent man would act in his own case; (iii) All sums which may have been paid under the terms of any compromise of any such suit, if the compromise was not contrary to the orders of the indemnifier and was one which it would have been prudent for the promisee to make.

Rights of the indemnifier


The Act makes no mention of the rights of indemnifier. However, his rights, in such cases, are similar to the rights of a surety under Sec.141, viz., he becomes entitled to the benefit of all the securities which the creditor has against the principal debtor whether he was aware of them or not.

Commencement of indemnifiers liability


Indemnity requires that the party to be indemnified shall never be called upon to pay. Indemnity is not necessarily given by repayment after payment. The indemnified may compel the indemnifier to place him in a position to meet liability that may be cast upon him without waiting until the promisee (indemnified) has actually discharged it.

Distinction between a contract of guarantee and a contract of indemnity. L.C. Mather in his book Securities Acceptable to the Lending Banker has very briefly, but excellently, brought out the distinction between indemnity and guarantee by the following illustration. A contract in which A says to B, If you lend 20 to C, I will see that your money comes back is an indemnity. On the other hand undertaking in these words, If you lend 20 to C and he does not pay you, I will is a guarantee. Thus, in a contract of indemnity, there are only two parties, indemnifier and indemnified. In case of a guarantee, on the other hand, there are three parties, the principal debtor, the creditor and the surety. Other points of difference are: 1. The liability of a promisor is primary and independent in a contract of indemnity. In a contract of guarantee, the liability of the surety is secondary, the primary liability being that of the principal debtor. 2. In the case of guarantee, there is an existing debt or obligation, the performance of which is guaranteed by the surety. In case of indemnity the possibility of any loss happening is a contingency against which the indemnifier undertakes to indemnify. 3. In a contract of guarantee, after discharging the debt, the surety is entitled to proceed against the principal debtor in his own name while in case of indemnity, the indemnifier cannot proceed against third parties in his own name, unless there is an assignment in his favour.

Mini-case
"I didnt receive the products. The supplier said the goods were detained in the Customs Office because Customs didnt find the original invoice attached to the goods. The supplier explained that its his companys policy was to issue original invoices only when quantities are above 5 units. He told me to pay for another 2 units for another $150 USD, but I have refused. I paid by Western Union. He registered on your website as a US company, but actually it is Chinese Company. All his information is fraudulent. His is a fraudulent company!" If you think their price is very attractive and want to deal with them, it is very necessary for you to verify that they are legitimate company and their contact information is correct. In this case, the fraudster is pretending to be a US company, but all his registered information is false. This can be judged easily by calling his company telephone number or by searching the company name on related state government websites.

Western Union is a dangerous payment method, it can be picked up anywhere in the recipients country, with no way of tracing the person who picked it up. The criminal remains anonymous. So it is a commonly used payment method for con-artists. So try to avoid adopting this payment method and consider other more secure payment methods like escrow. Questions 1. What would you understand if the seller requests you to send payment to another country instead of his registered country showed on the website? (Hint: Refer First Para of case) 2. Analyze the ways in which a person can find out the whether the company is fraudulent. (Hint: Take full knowledge about the product and company if you use virtual mode of transaction).

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